Federal taxes typically get the spotlight; however, state tax provisions often have an equally powerful influence on a company’s financial results. They shape the effective tax rate (ETR), drive key disclosures, and can materially affect financial statements. And while they rarely make headlines, understanding them is essential to avoiding costly surprises down the road.
Federal vs. State: Same Rules, Different Plays
The principles of ASC 740 apply to both federal and state income taxes. The challenge is that not every state conforms to federal rules. Some states track closely, while others “decouple,” creating differences in how deductions (such as depreciation), credits, or even net operating losses (pre-apportionment vs. post-apportionment) are handled.
For example:
- Texas Margin Tax counts as income-based and is therefore in scope for ASC 740.
- Ohio’s Commercial Activity Tax (CAT) is receipts-only and excluded from ASC 740.
These nuances are why companies need to carefully evaluate which taxes fall under the accounting standards.
Choosing a Methodology
There is no one-size-fits-all approach to calculating the state provision. Companies typically use one of these approaches:
- State by State – Precise, but labor intensive. Best for large, complex, or material operations.
- Blended Rate – Single weighted average rate. Faster, but can hide swings from individual states.
- Hybrid – The most common approach: model large states individually and blend the smaller ones.
- Pro Rata Allocation – Rare today. Simplistic and often misaligned with real results.
The right methodology depends on size, materiality, and disclosure requirements. With the new disaggregation requirements of ASU 2023-09, public business entities especially need more detail in their financial statements, which pushes many toward the more granular calculation of state-by-state reporting.
Another consideration is combined vs. separate filing. In combined-filing states, entities can share losses and credits. In separate-filing states, each entity files alone—preventing losses in one entity from offsetting income in another. This distinction can dramatically change the provision outcome.
Key Drivers of Complexity
Several factors make the state tax provision challenging:
- Rate Changes and New Laws: States frequently adjust tax rates or decouple from federal legislation. Timing matters. Laws are recognized at enactment, not when they become effective.
- Apportionment: Most states now use a single sales factor, but others still weigh property and payroll. These formulas can significantly shift how income is apportioned.
- Permanent and Temporary Differences: States often diverge from federal rules on items like depreciation, interest limitations, or R&D expenses.
- Credits and NOLs: Rules for usage and carryforwards vary widely. For example, Pennsylvania caps pre-2025 NOL use at 40 percent of taxable income per year, California suspended all NOL utilization for 2024-2026, while federal NOLs after 2020 are subject to an 80 percent limit.
- Return-to-Provision (RTP) Adjustments: Differences between estimated tax provisions and filed tax returns—often from updated apportionment or late credits—require true-ups. RTPs can add volatility to reported results.
Why It Matters for Financial Reporting
State taxes influence both current expenses and deferred balances, and they are central to the rate reconciliation. Importantly, they are presented net of the federal benefit of state (FBOS), meaning state tax expense is deductible for federal purposes, which lowers the overall ETR. Misstating this interaction can distort financial reporting.
Transparency is critical. Stakeholders and auditors expect clear disclosures that identify:
- The states driving the majority of the provision
- Significant valuation allowances
- The impact of law or apportionment changes
- Uncertain tax positions at the state level
- Additional ASU 2023-09 disclosures, such as qualitative explanations and jurisdiction-level detail
Final Thoughts
The state tax provision might not be the flashiest part of a company’s financials, but it is consequential to an accurate and proper income tax disclosure. From evolving state laws to varying methodologies, it requires careful attention and clear disclosure. Getting the state provision right isn’t just about compliance—it’s about accuracy, transparency, and trust in the financial statements.
To explore these issues further, watch the full webinar on demand and connect with our tax provision experts to discuss your specific challenges.
